Liquidity, Liquidity, Everywhere…

By Alen Mattich

Coordinated or not, central bankers worldwide have the same thing in mind: more of the same.

More monetary stimulus to stave off the global economy’s recent softening and to prevent the latest flare-up of the euro-zone crisis from making things worse is being lined up almost everywhere.

Because it’s worked so well so far.

Investors are primed for some positive news from the Federal Reserve this week. This will probably be limited to extending its forecast of how long policy will remain ultra accommodative, although there’s a pretty good chance it will also boost Operation Twist.

There might be some sterilized quantitative easing on offer, essentially a variation of Operation Twist, and a remoter possibility of unsterilized QE, although the Fed will probably want to hold the last option in reserve against the chance of a euro-triggered financial-markets meltdown.

The Bank of England is also likely to do more quantitative easing in July, when it next meets. The latest policy committee minutes suggest it only narrowly avoided adding at least £25 million of QE earlier this month.

The European Central Bank is less easy to read. On the other hand, a sharp deceleration of economic activity in Germany, together with outright recession across much of the periphery, suggests it is in a position to at least trim its key rate, even if it is constrained on bond purchases and other unconventional measures.

The Chinese are doing their bit to spur another bout of investment-led growth by cutting rates and pressing banks to do more lending. The Swiss and the Danes are printing money as a means of defending their currency targets.

Central bankers are unconcerned about being able to control the inflationary effects of the wall of money they’re creating. As Fed Chairman Ben Bernanke said, they are 100% certain of being able to control inflation.

The question is will he and the rest of the Fed, not to mention other central bankers at other central banks, have the backbone to do so when the time comes.

Martin Feldstein, the Harvard economist and President Emeritus of the National Bureau of Economic Research doesn’t think so.

If unemployment remains relatively high when inflation starts to rise, or if structural problems in the economy mean that growth remains subdued, central bankers will find it hard to be sufficiently aggressive. In open economies like the U.K., this will probably cause a vicious cycle of capital flight, currency depreciation and yet more inflation. And central bankers won’t be able to do a thing about it.

Keynesian economists like Paul Krugman have been scathing towards those worried about the potential inflationary effects of hugely-expanded central-bank balance sheets, because, during the past few years, inflation has been well behaved.

But people, including the Fed’s central bankers, were equally convinced that a U.S.-wide collapse in house prices was impossible in the years leading up to the bust. Those who warned about the property bubble were mocked as contemptuously then as the inflationists are now.

Comments (1 of 1)

When inflation hits, or even if or when interest rates become market rates, the Fed can't increase interest rates as it will decimate their own portfolio. Operation Twist, moving out on the yield curve, will blow up in the Fed's face as long rates will get the hardest and that is where their money is. Financial engineering is just painting over the economy's cracks, whether it is private business, individuals or governments.